United States

We are compelled to downgrade banks and investment banks to neutral in advance of the release of the Fed’s stress tests this Thursday. This downgrade also pushes the financials sector overweighting to neutral. Our worry is centered on a possible dividend cut/suspension given the lack of confidence the Fed has with regard to the economic recovery owing to COVID-19. Even if the Fed strikes a more balanced note on the banks’ cash buffers and capitalization and does not force them the chop their dividend payouts (bottom panel), we would still want to be on the sidelines at least until the election uncertainty lifts in November. A blue sweep would, at the margin, be negative for the banking sector (second panel). Moreover, following a near month-long rebound from the early May trough, banks have not been responsive to the steepening yield curve and this is disconcerting (third panel). Moreover, following a near month-long rebound from the early May trough, banks have not been responsive to the steepening yield curve and this is disconcerting (middle panel). Bottom Line: Downgrade the S&P banks and S&P investment banks indexes to neutral, which also pushes the S&P financials sector to a benchmark allocation. Please look forward to reading our upcoming Monday June 29 Weekly Report for a more detailed analysis on these two financials subgroups.      

Highlights Treasuries: Keep portfolio duration close to benchmark on a 6-12 month horizon, but continue to hold tactical overlay positions that will profit from modestly higher bond yields: Overweight TIPS versus nominal Treasuries, hold duration-neutral nominal curve steepeners, hold real yield curve steepeners. IG Tech: Given our positive outlook for investment grade corporate bond spreads, the Technology sector’s high credit rating and defensive characteristics make it decidedly un-compelling. However, Tech spreads are attractive compared to other A-rated corporate bonds. HY Tech: We want to focus our high-yield allocation on defensive sectors where a large proportion of issuers are able to benefit from Fed support. The high-yield Technology sector checks both of those boxes and offers attractive risk-adjusted compensation to boot. Feature Chart 1Three Treasury Trades As we have previously written, bond yields should move modestly higher over the course of the summer as the US economy re-opens.1 However, there are enough potential medium-term pitfalls related to US politics and COVID transmission that we aren’t yet comfortable with below-benchmark portfolio duration. Instead, we recommend that investors keep portfolio duration close to benchmark on a 6-12 month horizon, but add three tactical overlay positions that will profit from higher bond yields: Overweight TIPS versus nominal Treasuries Duration-neutral nominal Treasury curve steepeners Real yield curve steepeners All three of these positions have performed well during the past couple of months (Chart 1), and in the first section of this report we assess whether they have further to run. The remaining two sections of this week’s report consider the outlooks for investment grade and high-yield Technology bonds, respectively. Three Trades To Profit From Higher Yields 1) Overweight TIPS Versus Nominals Chart 2Adaptive Expectations Model TIPS breakeven inflation rates have moved up considerably since mid-March. Back then, the 10-year TIPS breakeven rate troughed at 0.50%. It currently sits at 1.31%. Despite the large move, TIPS breakeven inflation rates still have a considerable amount of upside. One way to assess how much is through the lens of our Adaptive Expectations Model (Chart 2).2 This model considers several different measures of inflation expectations (based on realized CPI inflation and surveys) and uses the difference between those measures of inflation expectations and the 10-year TIPS breakeven inflation rate to forecast the future 12-month change in the 10-year TIPS breakeven. At present, the model forecasts that the 10-year TIPS breakeven inflation rate will rise 23 bps during the next 12 months, bringing it to 1.54%. It’s important to note that our model is biased towards measures of longer-run inflation expectations. As a result, it can be surprised from time to time by large fluctuations in drivers of short-term inflation expectations, like the oil price. This year’s massive drop in oil – and concurrent decline in headline inflation – were the main factors that caused the 10-year TIPS breakeven inflation rate to fall so far below our model’s fair value. However, as we discussed in last week’s report, the oil price looks to have troughed and there is preliminary evidence that we might also be past the lowest point for headline CPI.3 Profit from rising bond yields by entering a duration-neutral yield curve steepener. We see TIPS continuing to outperform nominal Treasuries over both short- and long-run horizons. 2) Duration-Neutral Yield Curve Steepeners Chart 3Stick With Steepeners Another way to profit from rising bond yields without taking a large duration bet is via a duration-neutral yield curve steepener. One example would be a long position in the 5-year note and a short position in a duration-matched barbell consisting of the 2-year and 10-year notes. Alternatively, you could use the 2-year note and 30-year bond as the two legs of the barbell. These sorts of duration-matched trades where you take a long position in a bullet maturity near the middle of the curve and go short the wings are designed to perform well in periods of yield curve steepening.4  In the current environment, where dovish Fed guidance has dampened volatility at the front-end of the yield curve, any bond sell-off will be felt disproportionately at the long-end, leading to a steeper curve. The only problem with this proposed trade is that it is no longer cheap. The spread between the 5-year bullet and 2/10 barbell is -6 bps and the spread relative to the 2/30 barbell is -3 bps (Chart 3). What’s more, the 5-year bullet trades expensive relative to the 2/10 and 2/30 barbells, according to our fair value models (Chart 3, bottom panel). However, for the time being we are inclined to overlook stretched valuations. The 5-year bullet does appear expensive but it has been more expensive in the past, most notably during the last zero-lower-bound episode from 2010 to 2013. Similar to then, the market is now priced for an extended period of a zero fed funds rate. We would not be surprised to see bullets become much more expensive in that sort of environment, and possibly even return to extended 2010-2013 valuations.   We recommend holding onto duration-neutral yield curve steepeners, despite unattractive valuations. Specifically, we favor going long the 5-year bullet and short a duration-matched 2/10 barbell. 3) Real Yield Curve Steepeners Chart 4Higher Inflation Means Steeper Real Yield Curve The final position we recommend is a steepener along the real yield curve. We first recommended this trade on April 28 when a plunge in oil (and spike in deflationary sentiment) caused the real 2-year yield to jump to 0.28% compared to a real 10-year yield of -0.70%.5 Since then, the real 2-year yield has collapsed to -1% compared to a real 10-year yield of -0.87%. Although the real 2-year/10-year slope is once again positive, it has typically been higher during the past few years (Chart 4). We therefore expect further steepening as long as the oil price and headline inflation continue to recover from April’s lows. Much like during the 2008/09 financial crisis, the combination of the Fed’s zero-lower-bound forward guidance and a massive drop in both oil and headline inflation caused short-dated real yields to jump. Subsequently, this led to a massive steepening of the real yield curve, once the oil price and headline inflation started to recover. We believe that same dynamic is playing out today. Investors should continue to hold real yield curve steepeners, at least until rebounding oil and headline CPI return short-dated inflation expectations to more reasonable levels. Investment Grade Tech Risk Profile Technology accounts for 9% of the overall Bloomberg Barclays investment grade corporate index, which makes it the second biggest industry group, after Banking. Its large index weight is due to the presence of three tech giants: Microsoft (Aaa-rated), Apple (Aa-rated) and Oracle (A-rated) which, combined, constitute 38% of the Tech sector.  Investment grade Technology is a highly defensive corporate bond sector. In sharp contrast with the equity market, Technology is a highly defensive corporate bond sector. That is, it tends to outperform the overall corporate bond index during periods of spread widening and underperform during periods of spread tightening. This largely comes down to the fact that Tech has a higher credit rating than the overall corporate index. Twenty five percent of the Tech sector’s market cap carries a Aaa or Aa rating compared to just 9% for the overall index (Chart 5). Further, of the high-flying FAANG stocks that garner a lot of attention from equity analysts, only Apple is a significant presence in the Technology bond index.6 Chart 5Investment Grade Credit Rating Distributions* Chart 6IG Technology Risk ##br##Profile The Tech sector’s defensive nature is confirmed by looking at its duration-times-spread (DTS) ratio and historical excess returns (Chart 6).7 The sector’s DTS ratio is consistently below 1.0, and its excess returns show a clear pattern of outperformance during periods of spread widening and underperformance during periods of spread tightening. Valuation In terms of valuation, although the Tech sector does not offer a spread advantage over the corporate index – which should be expected given its higher credit rating – we find that it trades cheap relative to its comparable credit tier (Table 1). Tech offers an option-adjusted spread of 115 bps versus 111 bps for the A-rated corporate index, and the sector still appears attractive after controlling for duration differences by looking at the 12-month breakeven spread. In absolute terms, Tech sector spreads are just above their median since 2010. The A-rated corporate index spread currently sits right on top of its post-2010 median. Table 1IG Technology Valuation Balance Sheet Health Chart 7IG Technology Debt Growth The Technology sector added a large amount of debt during the last recovery. The par value of the Tech index’s outstanding debt has grown 5.2 times since 2010 compared to 2.4 times for the benchmark. As a result, Tech’s weight in the corporate index has more than doubled, from 4% to 9% (Chart 7). However, earnings have done a pretty good job of keeping pace with the large increase in debt. The market cap-weighted net debt-to-EBITDA ratio for the investment grade Tech index is only 2.4, and the sector’s average credit rating has been stable since 2010. At the individual issuer level, there are 58 issuers in the Tech index and only 4 currently have a negative ratings outlook from Moody’s (Appendix B). What’s more, of the 16 Tech sector ratings that Moody’s has reviewed this year, 12 have been affirmed with a stable outlook, 1 was assigned a positive outlook and only 3 were assigned negative outlooks. Macro Considerations Chart 8Technology Sector Macro Drivers The Tech sector can be split into three major segments that have distinct macro drivers: Software (26% of Tech index market cap, includes Microsoft and Oracle) Hardware (29% of Tech index market cap, includes Apple, IBM and Dell) Semiconductors (24% of Tech index market cap, includes Intel and Avago Technologies) Software investment has been in a structural bull market for many years, and should remain resilient during the COVID recession as demand for remote working solutions increases. While we only have data through the end of March, software investment did not see the same collapse as other sectors during the first quarter (Chart 8). The Hardware and Semiconductor segments are more cyclical and geared toward manufacturing. As such, their macro outlooks were already challenged pre-COVID, due to the US/China trade war and manufacturing downturn of 2019. Both US computer exports and global semiconductor sales were showing signs of life near the end of last year, but were decimated when the pandemic struck in 2020 (Chart 8, panels 3 & 4). A revival in this space is contingent upon continued gradual re-opening and a return to economic growth. More optimistically, US consumer spending on personal computers and peripheral equipment has not fallen as much as broad consumer spending during the past few months (Chart 8, bottom panel). In the long-run, the 5G smartphone rollout is a significant structural tailwind for both semiconductor issuers and Apple. Meanwhile, the threat of significant regulatory crackdown on Tech firms remains a long-run risk. Our sense is that any push toward stricter regulations won’t have that much impact on Technology bond returns. This is because the subjects of most lawmaker scrutiny – Facebook, Amazon and Google – are largely absent from the Bloomberg Barclays Tech index. Investment Conclusions We expect that investment grade corporate bond spreads will tighten during the next 6-12 months. Against this positive back-drop, investors should focus exposure on cyclical (lower-rated) sectors that offer greater expected returns. With that in mind, the Tech sector’s high credit rating and defensive characteristics make it decidedly un-compelling. However, Tech does offer a slight spread advantage compared to other A-rated bonds and the macro back-drop is reasonably supportive. We would therefore recommend Tech bonds to investors looking for some A-rated corporate bond exposure. But in general, we prefer the greater spreads on offer from sectors that occupy the high-quality Baa space, such as subordinate bank debt.8 High-Yield Tech Risk Profile High-Yield Technology’s credit rating profile is similar to that of the overall benchmark, but with a slightly larger presence of low-rated (Caa & below) issuers (Chart 9). The largest issuers in the space are Dell (5.7% of Tech index market cap, Ba-rated), MSCI Inc. (5.1% of Tech index market cap, Ba-rated, see copyright declaration) and CommScope (8.1% of Tech index market cap, B-rated). High-yield Tech recently transitioned from being a cyclical sector to a defensive one. Interestingly, the high-yield Tech sector recently transitioned from being a cyclical sector to a defensive one. The sector behaved cyclically during the 2008 recession, underperforming the index when spreads widened and outperforming when they tightened. But Tech then outperformed the High-Yield index during the spread widening episodes of 2015 and 2020. Based on the sector’s low DTS ratio, this defensive behavior should persist for the next 12 months (Chart 10). Chart 9High-Yield Credit Rating Distributions* Chart 10HY Technology Risk Profile Valuation The High-Yield Technology option-adjusted spread (OAS) is significantly lower than the average OAS for the benchmark High-Yield index. However, it offers a spread premium compared to other Ba-rated issuers (Table 2). Adjusting for duration differences by looking at the 12-month breakeven spread makes high-yield Tech look significantly more attractive. The high-yield Tech spread would have to widen by 146 bps for the sector to underperform duration-matched Treasuries during the next 12 months. This compares to 96 bps for other Ba-rated issuers and 152 bps for the overall junk index. Table 2HY Technology Valuation It is apparent that the Tech sector’s low average duration (Chart 10, bottom panel) is a major reason for its relatively tight OAS. On a risk-adjusted basis, high-yield Tech valuation actually appears quite compelling, with a 12-month breakeven spread only 6 bps below that of the overall index. Balance Sheet Health Chart 11HY Technology Debt Growth The amount of outstanding high-yield Technology debt has grown a bit more rapidly than overall junk index debt since 2010 (Chart 11). As a result, Technology’s weight in the index has increased from 5% in 2010 to 6% today. At the issuer level, the Tech sector should benefit from having a large number of issuers that will be able to take advantage of the Fed’s Main Street Lending facilities. To be eligible for the Main Street facilities, issuers must have less than 15000 employees or less than $5 billion in 2019 revenue. Also, the issuers must be able to keep their Debt-to-EBITDA ratios below 6.0, including any new debt added through the Main Street programs. Of the 43 high-yield Tech issuers with available data, we estimate that 30 are eligible to receive support from the Main Street facilities (Appendix C). This even includes 11 out of the 16 B-rated issuers. Typically, we don’t expect that many B-rated issuers will be eligible for the Main Street facilities, which makes this result encouraging for Tech sector spreads. Investment Conclusions We recommend an overweight allocation to high-yield Technology bonds. As we wrote last week, high-yield spreads appear too tight if we ignore the impact of the Fed’s emergency lending facilities and consider only the fundamental credit back-drop.9 With that in mind, we want to focus our high-yield allocation on defensive sectors where a large proportion of issuers able to benefit from Fed support. The Technology sector checks both of those boxes and offers attractive risk-adjusted compensation to boot. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B Table 4Investment Grade Technology Issuers Appendix C Table 5High-Yield Technology Issuers   Ryan Swift US Bond Strategist rswift@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 2 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 4 For an explanation of why this works please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 6 Of the other FAANG stocks: Google accounts for just 0.5% of Tech bond sector market cap, Facebook has close to no debt, Amazon is included in the Consumer Cyclical corporate bond index and Netflix is included in the Media: Entertainment sector of the High-Yield index. 7 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 8 For more details on our recommendation to overweight subordinate bank bonds please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification